Pension Change to Put U.K. Plans Into
Bondage

Buried at the bottom of
British Telecommunications
' poor second-quarter results is painful evidence of why U.K. pension-fund managers might shift more and more of their investments out of stocks and into corporate bonds over the next few years.

BT said Thursday it will pay a &pound;600 million "special and deficiency contribution" to its employee pension plan in December. Later, company officials explained that &pound;200 million is for, as the British quaintly put it, "top-up" payments, necessitated by the drop this year in value of the stocks in the pension-fund portfolio.

This comes as the debate in the City over a long-term impending investment rotation begins to intensify. A U.K. regulatory accounting change, FRS 17, that could push pension-fund managers toward bonds was approved one year ago, but few paid it much mind until now, says Andrew Roberts, Merrill Lynch fixed-income strategist. The change came two weeks ago, he adds, when British drug-store chain Boots said it had moved its entire &pound;2.3 billion employee pension fund to 100% in bonds over the past 18 months from 75% in equities, to reduce risk to members.

A few others, such as ICI and Sainsbury, have initiated less drastic but similar moves, and more companies are likely to mimic the changes, at least partially. U.K. pension funds have lost more than 20% of their value over the past two years and the FRS 17 introduction is going to deepen the problems caused by weak equity returns, says U.K. equity strategist Steve Russell of HSBC. A shift to fixed-income investments has broad implications for both the U.K. stock and corporate-bond markets, while FRS 17 rules could hurt future earnings or dividends at companies with underfunded pension schemes. It could also affect companies' credit ratings and cost of debt.

Under FRS 17, which will be implemented in steps by June 2003, U.K. companies for the first time must recognize their employee pension plans' surplus or deficits in full on their corporate balance sheets, as well as "mark to market" the value of assets in their pension funds. Technically, any deficit could reduce what's called "distributed reserves," from which dividends are paid. And dividends, of course, ultimately come from earnings.

BT, for example, said it would have been 100% funded at the end of 2000 under FRS 17, but it is likely to show a deficit of &pound;4 billion at the end of December, thanks to the drop in stock prices.

That plunge over the past 18 months and the high average equity exposure of British pension funds would have presented problems to some companies anyway, but FRS 17 compounds things, says Russell. And if equity prices were to continue to decline, topping up an underfunded pension plan is particularly worrisome at a firm where the fund is similar in size or bigger than the corporation's market capitalization, according to Merrill Lynch, which just published a list of vulnerable companies (see accompanying table).

One company has already been waylaid by FRS 17. Eliza Tinsley Group, a small agricultural manufacturing firm, will cut its future dividends by 66% because of a pension deficit and FRS 17.

There are wider effects as well. Merrill's Roberts says the combination of relatively high levels of equity ownership by British pension funds, which average 73%, a maturing U.K. labor force and FRS 17 will produce a switch to bonds over the next five to 10 years. He estimates just a 10% or so reduction in the average equities allocation in pension assets to 60%, which means some &pound;75 billion will exit stocks and move to the fixed-income market. "It will be massively supportive" of bond prices, particularly the relatively small British corporate bond market, he says. That's a market worth about &pound;225-&pound;250 billion now.

HSBC's Russell concurs. The flip side is that the changeover will undermine support for equity prices. For example, he estimates that a change in allocation by pension funds to 50% equities translates into roughly 7% of the value of the FTSE All Share index. The impact will be "drip, drip" subtle, as Russell puts it. But over the years the mounting ardor for bonds could absorb demand that otherwise would have pushed up stock prices, says Russell, who estimates over three years the switch could depress stock prices up to 5%.

So will other companies follow Boots? The company's head of corporate finance, John Ralfe, thinks so. Now that the issue has gotten some publicity, it can't be buried anymore, and analysts and shareholders will begin to ask questions about a firm's pension liability, he believes. And don't underestimate the herd instinct among finance directors, he adds.

Though some profit-taking set in Friday, the Dow Jones Stoxx pan-European index gained about 4% on the week, to finish at 291.34. Technology and telecommunication stocks led the rally, and most industry groups participated. The market is up 24% from its September 21 lows but still down 19% for the year. The DJ Stoxx 50, which tracks 50 European blue-chip shares, also jumped 4% to 3,643.93. Alcatel, Nokia, Siemens and Philips all had big weeks.

Markets already were rising sharply by Thursday, when both the European Central Bank and the Bank of England followed the Federal Reserve's lead by cutting their benchmark interest rates by one-half percentage point, to 3&frac14;% and 4%, respectively.

The market is still trying to decide whether this furious rally is just a bounce from very low valuations in September or one that indicates the strong dose of monetary stimuli will produce an economic recovery next year, says Stuart Fraser, head of European equity investments at Standard Life Investments. "But investors are getting more relaxed about the recovery," he adds. Even if it is a bear market rally, it could last a while, perhaps six months, he says.

More bullish is Marc Pignatelli, head of European equities at Schroders, who believes the market is sniffing out a profits recovery. "Last Monday the market digested some of the worst conceivable NAPM figures and rallied," and that's a good sign, he says. (The National Association of Purchasing Managment released service-sector data that were far worse than expected.)

The market is pricing the duration of the recession, he believes. Market psyche has changed, and it's not interested now in earnings next year but peak profits -- that is, what a company's assets can return to three years out when the global economy has recovered. Pignatelli grants that this rally is a liquidity-fueled bubble. But by about the time a hangover would come, investors will see that corporate earnings will be improving, and that will bring about the next upswing, he contends.

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